Fed spoils the Christmas party
Posted 20 December 2024
Not only did the ‘Santa Rally’ not arrive this year, but global stocks had a notable sell-off on Wednesday night. This came after the US Federal Reserve (Fed) told investors not to expect many interest rate cuts in 2025, a pretty stark change from the giving mood they displayed last Christmas.
On a broader level, though, we end 2024 in a pretty similar mood to 2023: capital markets have just had a great period of returns, excited about the economic growth that comes next. Having ‘priced in’ that growth already, markets look to be steady in the months ahead rather than spectacular. We said that a year ago, and then both growth and returns turned out even better than expected. That could happen again, but we should not bank on it.
Meanwhile, UK yields rose to the highest levels in this century, mostly driven by US events, but partly because the Bank of England (BoE) kept rates on hold. November’s inflation data remained above target. This is a problem for government debt if they stay elevated. We cover more of this in an article below.
We shouldn’t be surprised at the Fed’s big surprise.
The Fed cut interest rates by a quarter of a percentage point on Wednesday night – as expected – but surprised markets by substantially shifting its ‘dots plot’ (a graph showing where committee members expect interest rates to be at different points out into the future). The previous dots plot projected a whole percentage point cut through the course of 2025, while the new one suggests rates will be just half a point lower by the end of next year. The market response was panicky, with the S&P 500 selling off over 3%. The US dollar rose sharply.
We did not predict such a sudden shift. Although we did say in our 2025 outlook that markets were too optimistic about Fed cuts, we expected this to become apparent after January. The US economy has improved markedly since a summer soft patch (which was when the Fed started sounding more dovish) and looks strong. Incoming president Donald Trump has promised pro-growth domestic policies and anti-trade foreign policies. The inflation risks from this scenario are plain to see.
It was interesting that the ‘Magnificent Seven’ (Mag7 – Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia, Tesla) tech stocks were hit the hardest. Those companies are incredibly cash rich, so on paper they should not be hurt by higher aggregate borrowing costs. As ‘long-duration investments’, however, their valuations are rate-sensitive. The fact they sold off more than other stocks suggests that this was a valuation correction rather than anything to do with growth expectations – in other words, markets pulling back after getting overexcited.
Trump policy fights are looming.
One reason that the Fed’s hawkishness surprised markets is that it feels like chairman Powell is picking a fight with Trump, who we know wants lower rates during his term. Fed members are not really picking a fight of course; they are just pointing out the inflation risks as any responsible policymaker would. But we can be confident that Trump will not take it well, and a fight over Fed independence – with or without Powell at the helm – now looks more likely.
That is not the only policy fight coming up either. Trump’s Republicans recently agreed a bipartisan budget bill, only for Trump and top adviser Elon Musk to come out swinging against it. Musk – the soon-to-be head of ‘government efficiency’ – threatened the political positions of any Republicans that vote for the budget. Some form of agreement is needed soon, or else we might see another Christmas US government shutdown.
Budget brinkmanship used had become common in Washington – to the detriment of the US economy – but it has been less of an issue in recent years. Musk the disruptor seems to be bringing it back. We still have a month until Trump takes office, but it already looks like his second term will not be a smooth ride.
Go again in the New Year?
US stocks have rallied so strongly this year because US corporate profits have been so much better than elsewhere. That profit outlook is not (yet) shaken by rates staying higher for longer, so investors still have plenty of positives. We should note, however, that fewer rate cuts will be a problem for smaller debt-laden companies. More growth will help on the revenue side, but there is a clear subsection of US businesses which have suffered during the high rate era.
The Fed’s hawkish turn is also bullish for the dollar. It reflects continuing US exceptionalism, and yet again we saw every other currency falter this week. However, it was notable that US equities got more of a knock-down than elsewhere – the Mag7 getting the biggest knock-down of all. This is not because things have gotten worse for the US compared to elsewhere, but because the US was the site of past overexcitement.
As we covered in our outlook, there are longer-term problems that arise from the US’ continued economic and financial dominance. For now, though, this week’s price correction makes US stock valuations look marginally better. That sets up the start of 2025 nicely.